The Hindu Business Line : Holding court on investment options

AKBAR was holding court. "I am in a predicament. As you know I have immense wealth, and the royal coffers are overflowing; I have decided to invest. I would like good suggestions from my ministers."

Raja Man Singh, one of the nine gems, said, "O king! I suggest the stock market. It has been proven that the stock market returns around 10 per cent a year. You pick great companies, like Pfizer or GE, and make good returns."

Tansen, the court singer, intervened, "Jahanpanah! Let's not forget companies like WorldCom and Enron. If you want the advantage of investing in stocks without the risk of losing money, I think you can invest in mutual funds."

"Bah," sneered Raja Man Singh. "More than 90 per cent" of mutual funds failed to beat the market consistently."

Tansen shot back, "Well, you can simply invest in mutual funds that mirror the S&P 500 index and take advantage of the growth in the stock market. Also, mutual funds are run and managed by major companies. Each firm offers a plethora of mutual funds for an investor to choose from."

"Interesting arguments," observed Akbar. I want to hear more."

Man Singh said, "Investing in stocks provide additional opportunities such as option trading, margin trading, short selling and trading during the hours of exchange.

"The stocks are traded during the exchange hours, which are between 9.30 a.m. to 4.00 p.m EST. So if you want to make quick money, and if the market is moving higher, you can invest in a stock that is going up in the morning and sell it by noon cashing in quick profits. A mutual fund cannot offer any of these advantages. Let me prove it.

"Let's say, trading begins on Monday, September 12th. When will all investors who are buying and selling know the price?"

Tansen reluctantly answered, "They will not know the price until the end of the day."

Akbar verified, "Thus, S&P 500 might make a substantial move in the morning but a mutual fund investor cannot take profits as he has to wait till the end of the day to learn the price of a mutual fund."

Raja Man Singh triumphantly added, "Also, an investor cannot do short selling, option trading and buying on margins in any of the mutual funds."

"Isn't there a common solution, for this?" asked Akbar.

"Yes. Spiders, diamonds and Qubecs," said a visitor from a neighbouring kingdom and hurriedly left the court.

The entire assembly, including the king, was puzzled.

Akbar turned to Birbal. "This is a challenge for you. I need to know what that visitor meant. I give you three days. If you don't answer, your head is in danger."

On the fourth day, the court reassembled. In walked Birbal and launched into his tirade: Recently, a popular investment vehicle exchange-traded funds (ETFs) has been created for common investors. This helps active investors, who want to take advantage of the diversification of mutual funds along with the added benefits of stock trading,

"ETFs offer the diversification of a mutual fund as it is not a single stock but in turn mirrors a specific index along with the convenience of stocks; like trading during the hours of exchange, option trading, margin trading and also short selling. Thus exchange-traded funds offer more flexibility than mutual funds."

"The most popular exchange-traded funds are spiders or SPY. This is the first exchanged traded fund created for the individual investors and still the biggest exchanged traded fund in terms of the assets in the fund.

"This mirrors the S&P 500 index and thus offers the flexibility of investing in multiple stocks under one name. Whenever S&P 500 goes up, the ETF is also likely to move up and thus when S&P 500 goes down, the ETF SPY will also go down. So an investor can easily profit from the moves of S&P 500, with no surprising shocks of individual stocks.

"The other popular exchange-traded fund is Qubecs or QQQQ. It mirrors the 100 stocks of NASDAQ. So in general, when NASDAQ goes up, this ETF is also likely to move up."

"All right," said Akbar. "But, how do I make use of this?"

Birbal answered, "In the beginning of May, the NASDAQ market started rising slowly. So instead of investing in individual stocks, an investor could have simply bought the QQQQ at around $35, and in August it reached its peak of $40. That is a clean 14 per cent profit in less than four months. Once NASDAQ reached its peak around August, it started coming down. So an investor who wanted to make a nice profit could have either bought puts or sold QQQQ short."

Raja Man Singh was curious. He asked, "Are there exchanged-traded funds which mirror individual sectors too?"

"Absolutely." Birbal continued. "Say, you are confident about the energy sector for the rest of the year; then you can directly invest in an exchange-traded fund that tracks the energy sector. Similarly, there are ETFs that mirror the biotechnology sector."

Akbar asked, "What if an investor wants to invest in an exchange-traded fund that mirrors Dow?"

Birbal smiled, "That is what is known as Diamonds or DIA. This mirrors the 30 stocks that are part of the Dow industrial average."

Tansen had one question. "Normally, to invest in a mutual fund an investor opens an account with the company that manages the fund and invests in a specific fund. If one wants to invest in Vanguard S&P 500 or VFINX, one opens an account with Vanguard. What about ETFs?"

Birbal said: "An investor can easily open an account with any discount brokerage firm like AmeriTrade or E-Trade and trade ETFs like stocks. To sum up, an investor who wants to take the advantage of mutual funds with the added benefits of stock trading would prefer investing in ETFs. This is what our esteemed visitor suggested."

"Well done, Birbal." applauded Akbar. "However, I am curious. How did you find out?"

Birbal smiled, "Simple. For the past three nights, I stood outside our mysterious visitor's house and rang a bell in the middle of the night. In his deep slumber, he thought it was the opening bell of the stock market and began talking about trading and ETFs. I listened and learned whatever I could."

Akbar laughed heartily. "My dear Birbal," he said, "I hereby confer on you the title `Sultan of Stocks'."

The authors are publishers of www.wisepen.com

Racy@thehindu.co.in

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